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Issue No. 21 – April 11, 2005 Prescott, Arizona Systems@WiserTrader.com
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1.0 Trading
This issue will describe 3 filters that can be used with a flexible stock picking tool to independently create one’s own watch list. Stock picking tools found at the web site, such as Stock Picker RT, are essential to a successful trading system. To obtain help picking trading candidates, low cost stock and option advisories are also available at the web site http://www.wisertrader.com .
1.1 A Value Filter
First, let’s walk through an example of how intermediate term value stocks can be chosen. Intermediate term in this context means from several months up to 5 years. Compelling values can sometimes be found among stocks that have been beaten down. The question becomes how to distinguish between companies that have real value and those that are simply poor performers. Price alone is not a good measure of value. Besides a low price, a number of value indicators need to be employed.
A basic value indicator is the price to book ratio. Fair value of a stock is indicated by a price to book ratio of about 1. When a company files chapter 11 and its assets are sold, their worth is approximately equal to the value of issued stock. However, bond holders get paid first. Then there are the expenses of redistributing assets. Common stock holders get paid after the more senior notes and expenses are subtracted. To arrive at a higher probability of getting a full return on capital, the price to book ratio of a beaten down stock should be around 0.6 or less so that the stock is selling at a 40% discount to it actual book value. As unusual as this kind of bargain might sound, there were 428 such stocks last week. Out of this group 135 were traded on the NASDAQ, NYSE or AMEX. Over the Counter (OTC) stocks are avoided for this kind of exercise. It is not that they are automatically deficient. Some very good stocks trade on the OTCBB. The reason they are not considered is that OTC reporting requirements are not as strict as for the three major exchanges and data needed for their evaluation may not be readily available in a standard form.
© 2005 Desert Mountain Systems, LLC. Members of wisertrader.com are neither licensed brokers nor licensed advisors. Trades discussed represent recommendations made by the editor for the wisertrader.com portfolio. The newsletter and web site are for information only and should not be considered as personal advice. While it is believed that the posted information is factual, mistakes can be made in transcription. Investors should trade stocks only after verifying all information and consulting with a licensed broker or adviser
Many of the above 135 low price to book stocks trading on the three major exchanges have been beaten down for one reason or another. It is more likely that a promising stock would be fairly priced or over priced in the current market environment. Clearly something has happened to lower investor perceptions of these stocks either fairly or unfairly. Stocks are sometimes beaten down for missing earnings guidance by as little as a penny per share. The same can happen for a stock that meets or even exceeds its earnings guidance but lowers its future sales guidance. Investor perceptions are influenced by analyst’s expectations, however realistic or unrealistic they might be. Current perceptions are not always a clear guide to how a company will perform in the future. A company’s value, however, is clear cut.
Companies that have tangible earnings are perceived to have real value. To give us some assurance that further price declines will be limited, we should look for companies that are reporting real earnings. Out of the 135 companies, there were 35 that reported real earnings. Of that 35, we now need to ask, which ones are likely to improve their price performance. The answer is going to be found in those that report year over year earnings growth. There were 20 that reported year over year earnings growth.
Another measure of value is the price to sales ratio. Companies are typically sold at one to two times their annual sales. So from this perspective, the price to sales ratio should be 2 or less. If the company is likely to be sold, we would look for our 40% discount in the form of a price to sales ratio no greater than 1.2. There were 17 companies with a price to sales ratio of 1.6 or less.
We also look for year over year sales growth. All 17 met this requirement.
Another popular measure of value is price to earnings. A fairly valued stock should have a PE ratio of 16 or less. There were 8 out of this group meeting that requirement.
The final criteria involve free cash flow. Free cash flow per share = (Cash from operations – Capital expenditures – Dividends paid) / Average Shares Outstanding. Free cash flow per share must be a positive number. This reduced the number of interesting stocks down to 5. The final requirement before looking at their details is for the ratio of price to free cash flow per share be less than or equal to 10. We lost one more. There were only four companies that met all the requirements up to this point. We can take a look at their details in Table 1.
Table 1
Potential Value Stocks
|
|
ALGI |
FSF |
GM |
JLN |
|
Price |
$5.369 |
$23.50 |
$29.38 |
$3.99 |
|
Price/Book |
0.49 |
0.32 |
0.60 |
0.55 |
|
Exchange |
NASDAQ |
NYSE |
NYSE |
AMEX |
|
EPS 12 months |
$2.13 |
$10.52 |
$10.38 |
$0.49 |
|
EPS growth 12 months |
62.6% |
41.4% |
52.2% |
44.1% |
|
Price/Sales |
0.17 |
0.97 |
0.09 |
0.08 |
|
Sales Growth 12 months |
26.9% |
45.2% |
4.3% |
15.6% |
|
PE |
2.6 |
2.2 |
5.9 |
8.7 |
|
Free cash flow/share 12 months |
$3.05 |
$15.71 |
$4.62 |
$1.64 |
|
Price/Free cash flow per share |
1.8 |
1.5 |
6.4 |
2.4 |
|
Market Cap |
$8.2M |
$780.7M |
$16.594B |
$10.4M |
|
Average Volume – 3 months |
10,444 |
8,636 |
9,781,227 |
5,227 |
The four stocks range from large cap to micro cap. There are many ways to further reduce the selection. We can tighten the above criteria to screen for companies that have continuous year over year earnings and sales growth for the past 5 or 7 years. The small volumes for 3 of the stocks should not be an issue for an investor looking to hold a stock for an extended period. At some point we have to look at price charts and other fundamentals describing prospects for growth. Since the list is small that is where we will go next.
American Locker Group Incorporated (NASDAQ: ALGI) experienced a 40% price decline in February when the US Post Office did not renew it’s approximately $25,734,000 contract that was responsible for approximately 52% of the company's total sales in 2004. Another drop in price occurred in March when it announced that it had retained Compass Advisory Partners, LLC to provide strategic consulting services with respect to potential restructuring and cost reductions. If the book value remains unchanged while earnings, sales and cash flow numbers are reduced by half, the company seems to still have an attractive value. The company has been in operation for more than 30 years.
Financial Security Assurance Holdings Ltd. (NYSE:
FSF) provides financial guaranty insurance on asset-backed and municipal
obligations. The company had an initial public offering in 1994 at $20 per
share. According to the way management calculates book value; up to 33% of the
book value may include the estimated present value of future income from insurance
premiums that have not yet been collected. A portion also includes a $100
million note due July 15, 2103 and is callable after July 31, 2008. I am particularly intrigued
by FSF because it is 99.1% owned by insiders, mostly securities underwriters.
General Motors Corp. (NYSE: GM) has two core businesses: Automotive and Other Operations and Financing and Insurance Operations. The 5 year expected PEG ratio is 7.84. While GM is the only of the 4 stocks for which this estimate is available, it is a clear warning of anticipated slow growth. A respectable PEG value is around 1.
Jaclyn, Inc. (AMEX: JLN) designs, manufactures, distributes and sells women's and children's apparel, and handbag products. Over the past 6 months revenues rose 8% but income fell 19% due to increased expenses. This is a business with a low profit margin. A February press release stated, ". . . sales and earnings for the second half of fiscal 2005 are expected to be significantly below last year's second half, and, as a result, full year results are anticipated to be lower than in fiscal 2004." This was immediately followed by a 38% drop in share price.
In conclusion, JLN and GM may not be good candidates while ALGI and FSF merit further investigation for intermediate term investing. In no case should any of these stocks be expected to recover within the first year. While both ALGI and FSF have good value ratios, some kind of catalyst that would spur profits needs to be identified. Unfortunately, that kind of information is not found in a data base and can not be picked up by a stock filter.
1.2 An Insider Buying Filter
An insider buying filter has been used to replace the Stephen Cooper Stock Candidate Filter on the website and in the newsletter. Insiders have frontline knowledge of what is taking place at a company. Consequently, they should be most informed about those things that will impact the cost of the company's stock. Research has shown that portfolios of insider buy transactions that were created on a rolling 12-month basis, outperformed the market by over 7% a year during the 10-year period ending in 1996. Furthermore, two-thirds of these extra returns were earned once a 30-day period had passed since the transaction, indicating that the lag in reporting of insider transactions may not prevent outside investors from benefiting from the knowledge about the transactions. On the flip side, however, studies have shown that data concerning sell transactions tends not to be useful in garnering extra investment returns. Insiders may sell company stock for any number of reasons. But when they buy, they expect to profit. Trading by insiders is highly regulated by the government. The Securities and Exchange Commission (SEC) requires insiders to file several reports outlining their transaction histories. These reports include Forms 3, 4, 5, 144 and 13D.
It may not be wise to base your buy and sell decisions solely on insider data. However, before you buy or sell a stock, it may be useful to see what the inside money is up to. The new filter screens for companies that have had a "significant" level of insider buying. In this case, it looks for those companies with at least three insider buys in the last six months. It next seeks companies that have had more shares of stock purchased by insiders than have been sold.
The next set of criteria limits the market capitalization of the companies to a range of $50 million to $1 billion. These companies tend to have less of a following than large-cap companies such as Microsoft, and companies that garner less market attention offer a greater potential for "surprises" that could allow them to offer returns greater than the overall market. In fact, research has shown that the insider buy transactions of small- and mid-cap companies have outperformed similar transactions by insiders of large-cap companies.
The next screen eliminates over-the-counter (OTC) stocks. Exchanges have listing requirements that establish minimums for company size, share availability, and financial strength. The filter excludes companies categorized as part of the Miscellaneous Financial Services and Real Estate Operations industries, which eliminates closed-end mutual funds and real-estate investment trusts (REITs).
The last screen requires the number of net shares of stock purchased (shares purchased by insiders minus shares sold by insiders) to be at least 5% of the overall number of shares outstanding.
The insider screen here is not meant to independently generate a list of investment candidates. Instead, these are companies that are experiencing above-average insider buying activity-a signal that they may warrant further analysis. To buy or sell strictly on what the insiders are doing is not a wise investment strategy. However, to ignore what the insiders are doing may be an investment mistake.
1.3 A Cash Rich Company Filter
A filter that finds cash rich companies is replacing the covered call writing filter. A healthy cash position provides important flexibility and safety to a firm. Cash-rich firms should be able to more easily meet their debt obligations, decreasing the probability of a creditor weakening the position of the equity investors or even gaining control of the firm. During an economic slow-down, cash allows a cyclical firm to continue its research and development efforts, as well as undertake capital expansion or productivity improvements, in anticipation of an economic rebound. Firms with excess cash positions can also elect to distribute the cash to shareholders in the form of dividends—although double taxation is a weakness to the high payout strategy. The firms pay corporate taxes when they earn the money and shareholders must pay taxes at their marginal tax rate when they receive the dividend. To avoid the double tax, many firms have chosen to use excess cash to repurchase shares on the open market. This helps to boost the share price in the short term by providing demand for shares. And with fewer outstanding shares, the same level of net income boosts earnings per share. Firms with excess cash can also attempt to use the cash strategically to broaden their product lines or diversify into new areas. This can be accomplished either through direct capital investment or the outright purchase of another firm.
Cash-rich firms can also be attractive acquisition candidates. While much more common in the leveraged buyout craze of the 1980s, the cash prize reduces the actual purchase price of the firm and the cash flow that allowed the cash hoard to be built helps to service the debt incurred acquiring the firm.
A high cash position can also be a disadvantage. Cash is generally defined as cash plus marketable securities that are readily convertible into cash. This would consist of bank deposits and short-term instruments such as Treasury bills. The cash position may reduce profitability if it earns a lower rate of return than other assets in the company. One would expect any corporate investment to earn more than the money market rate in the long run.
When finding firms with large cash balances, the critical question becomes: Why are they holding on to the cash? Often it points to a firm in a mature industry with little growth prospects. The firm may have reasonable profit margins, but little need for additional capital. For such a firm, the need for a good management team is especially important. Unlike a start-up, which must pass the tests of the capital markets to raise cash in an effort to expand into a new market, management has carte blanche to spend the firm's cash as it sees fit. Wall Street is filled with stories of firms divesting or spinning off unprofitable divisions that were acquired a few years back at rich premiums.
The amount of cash per share to the market price per share provides a useful indication of the cash level of the firm. General Electric may have $3 billion in cash, but this works out to a cash level equal to about 2.5% of the stock value (cash divided by market capitalization). Screening for firms with high proportions of cash to share price represents a reasonable starting point in tracking down cash-rich firms. When performing such a screen, it is important to exclude financials, because by the nature of their business they are required to hold large cash positions. Utilities were also excluded because of their regulated nature and overall low growth potential.
In addition to excluding financials and utilities, a filter requiring positive earnings from continuing operations for the last 12 months is specified as a minimum current profitability requirement, along with a minimum share price requirement of five dollars. Without the minimum share price requirements, bankrupt firms with a share price of a few pennies would dominate.
A screen specifying a minimum market capitalization (shares outstanding times price per share) was included to help ensure a minimum level of trading liquidity.
Our screen for high levels of cash looks at the ratio of cash per share to the stock price. As important as it is to look at cash, it is equally important to look at the financial obligations of the firm. A high level of cash per share could be quickly reduced when one considers the firm's short-term liabilities and long-term debt. A useful modification to the gross cash to price per share ratio is to subtract the short-term liabilities from cash to establish net cash per share, which provides a better measure of the excess cash on hand. Our screen looks for stocks with a net cash level of at least 40% of the stock price.
Screening for cash-rich stocks is not a simple process. Preliminary filters should screen for companies that not only have a high level of cash per share, but also a strong balance sheet, the potential for future earnings growth, and positive free cash flow per share.
2.0 Market Analysis
Industry leadership is given in Table 2 where leading industries are ranked from highest to lowest.
Table 2